Long Term Understanding of U.S. Economic crisis

Four years after the onset of the financial crisis — in March 2008 Bear Stearns was rescued from failure — we still lack a clear understanding of the underlying causes. Hundreds of studies and books have given us an increasingly detailed picture of what happened without conclusively answering why. Conventional wisdom has advanced competing theories: Wall Street types took too many risks, encouraged by lax government regulation; or pro-homeownership policies eroded mortgage-lending standards and created the housing bubble.

Actually, both theories are correct — and neither is. It’s true that Wall Street took too many risks while government regulators watched passively; it’s also true that the government’s aggressive promotion of homeownership contributed to real estate speculation. But the fact that these theories are not mutually exclusive suggests that both were consequences of some larger cause. Just so. What ultimately explains the financial crisis and Great Recession is an old-fashioned boom and bust, of which the housing collapse was merely a part.

The boom started with the decisive defeat of double-digit inflation in the early 1980s. Consumer price increases dropped from 14 percent in 1980 to 3 percent in 1983. As inflation fell, interest rates gradually followed (from 1982 to 1989, rates on 10-year Treasury bonds fell from 13 percent to 8 percent) when investors realized the decline was lasting. With interest rates falling, stock prices rose (from 1982 to 1989, they nearly tripled), and with a lag, housing prices did too. Consumer spending surged, as Americans skimped on saving and borrowed against swelling home values and stock portfolios.

All the good news (low inflation, high employment, rising stock and real estate prices) drove economic growth. Between 1982 and 2007, there were only two mild recessions. When prosperity was jeopardized — by the 1997 Asian financial crisis, the tech crash in 2000, the 9/11 attacks — the Federal Reserve seemed to defuse the threats. The economy seemed less risky. Economists announced the Great Moderation of business cycles.

Booms become busts because justifiable confidence becomes foolish optimism. So it was. Believing the world less risky, people took more risks. Investment banks and households increased their debt. Lending standards eroded, because borrowers’ repayment prospects were thought to have improved. Regulators relaxed oversight, because markets seemed more stable and self-correcting. On the fringes, ethical standards frayed; criminality increased. The rest, as they say, is history.